The Business of the markets

The business of making money on the stock market is serious business and requires emotional stability ( as your positions and money moves likes waves up and down), patience, and most importantly discipline . To that extend, it is very important to understand how this business makes money. Often it is this lack of basic understanding that results in the tons of horror stories that we hear about the market. If you don’t know your business, you can’t succeed in it. Applies everywhere.

The business of the stock market is essentially a business of managing probabilities and maintaining risk/rewards…..These are traits that you anyway use in your daily decision making in your life…its just that it happens subconsciously for other things but in the markets, you need to make those decisions more consciously….For example, lets talk about our decision to go to a restaurant for dinner…..Now whenever you eat out, you always carry the risk of a stomach infection or food poisoning. However for most people,this is a rare occurrence and is therefore a reasonable risk to take. If on the other hand, if you always had an issue with your stomach whenever you ate out, how likely is it that you would go out to eat….very unlikely. That’s risk/reward at work. While you were making the decision, you were in reality processing the risk /reward of eating out. It just doesn't seem obvious to you. But in the markets,This needs to be at the centre of your focus

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Similarly, the law of probabilities is also the corner stone of the stock markets. Lets for a moment assume that you had zero knowledge about stocks and that you blindly bought and sold them. But you are disciplined. So you make sure you always cut your losses. At the start of any trade, there are only 2 things that can happen. You either win (ie make money) or you lose(ie lose money). So you always are at 50/50 probability for every trade. Now if you are disciplined enough to cut your losses on the losing trades and let the profitable trades run its course, over the long term the winners will more than compensate for your loosers. Let me illustrate this a little more using the example of a coin toss. When you toss a coin, you never know whether it will fall as heads or tails. Suppose you say heads you win and tails you lose and then we add a rule that every time we win we get 3/- (letting profits run) and everytime we lose, we lose 1/- (cutting your losses). Lets toss the coin 10 times……if we win 5 times and lose 5 times….we have made 5*3=15/- and lost 5*1 =5/- which is a net gain of 10/-….although we were right only 50% of the time. Change it to 7 loss and 3 wins (i.e right only 3 times out of 10) and still we are profitable by 2/- …..We are only slightly profitable BUT Most importantly we HAVENT LOST MONEY. ALSO NOTE THAT EVEN THOUGH you were wrong 7 times out of 10, you were still PROFITABLE!!!....Thats the above 2 concepts working for you.

This is a very very important basis to be a successful trader.  Every trading decision made should be based on the above philosophies. It is the foundation stone of this business.

If you didn’t know anything about the markets and bought and sold stocks blindly, it is still quite possible that you will make money if you follow the above basic rules. That is how important this is. Successful traders don’t know anything more than what an average person would know but they have understood the business of the stock market (i.e the rules above) and therefore make money.

Now on top of this,  if you were to further learn technical analysis which helps you do a better study of stocks using price patterns , you improve your probabilities , reduce risk and in turn can aspire to greater returns. You are able to get into the best trades, time your entries and exits all of which contribute to better returns.

Technical analysis is a vast subject. Its not an exact science. There are about  100 different kinds of analysis you can do on a stock but not one indicator can give you a perfect winner. Therefore the trick is to work with 2 or 3 indicators that you are comfortable with, understand them well and then build it into your trading methodology. You then take trades based on your methodology, use the law of probabilities and risk/reward mix discussed earlier to generate consistently profitable trades.

Developing your personal trading methodology (commonly referred to as a trading system) is a long drawn out process, involves trial and error, initial losses etc. It could take a few months before you are able to narrow down on one. There is no shortcut to this process. The perseverance pays off over the long term.

Over the next few blogs, we will discuss the elements that go into making of a system, the psychological makeup of a trader/investor, common issues, challenges, biases and lot lot more.......

Stay tuned and happy trading!